Section 2: Uses of Financial Ratios to Manage a Business

Five Types of Financial Ratios

• liquidity ratios

• activity ratios

• leverage ratios

• profitability ratios

• market ratios

Liquidity Ratios

A type of financial ratio that measures a company’s ability to meet its short-term obligations using its most liquid assets.

Activity Ratios

A type of financial ratio that evaluates how efficiently a firm utilizes its assets to generate sales or revenue; also known as efficiency ratios.

Leverage Ratios

A type of financial ratio that measures the extent to which a firm uses debt to finance its operations and growth

Profitability Ratios

A type of financial ratio that assesses a company’s ability to generate earnings relative to its revenue, assets, or equity.

Market Ratios

A type of financial ratio that analyzes a company’s financial performance in relation to its stock price or market value of a company

Cross-sectional Analysis

Comparing the financial ratios of one company to the same financial ratios of another company.

Financial Statements

Files or documents that provide a comprehensive snapshot of a company’s performance and operational efficiency.

Balance Sheet

A financial statement that presents a company’s financial position at a specific point in time.

Assets

Resources owned by the company that have economic value.

Current Assets

An asset or resource that is listed on the balance sheet that can be converted into cash within one year.

Fixed Assets

A tangible, long-term asset that a company owns and uses to generate revenue.

Liabilities

A company’s obligations to third parties.

Current Liabilities

A liability that is due within one year of the current date.

Long-term Liabilities

A liability that is due after one year of the current date.

Shareholders’ Equity

The owners’ claim on the company's assets after all liabilities have been settled.

Total Assets

The sum of current and fixed assets.

Total Liabilities

The sum of current liabilities and long-term debt.

Total Equity

The difference between total assets and total liabilities.

Income Statement

A financial statement that outlines the company’s financial performance over a specific period; also known as the profit and loss statement.

Revenue

The income generated from normal business operations.

Cost of Goods Sold (COGS)

The direct costs attributable to the production of goods sold by the company.

Depreciation

A non-cash expense that represents the gradual reduction in the value of a company’s fixed assets over time.

Earnings Before Interest and Taxes (EBIT)

Revenue minus COGS, SG&A, and R&D, expenses minus depreciation.

Net Income

The profit after all expenses, taxes, and interest have been deducted from total revenue

Current Ratio

A type of liquidity ratio that measures a company’s ability to satisfy its short-term liabilities with its short-term assets

Quick Ratio

A type of liquidity ratio that assesses a company’s ability to fulfill its short-term obligations without relying on the sale of inventory; also known as the acid-test ratio

Cash Ratio

A type of liquidity ratio that provides insight into a company’s ability to pay off short-term liabilities with its cash on hand

Agency Costs

Costs that are incurred by the firm when management and employees of a company do not act in the best interests of shareholders.

Average Collection Period

A type of liquidity ratio that calculates the average number of days it takes for a company to collect its receivables

Accounts Receivable (A/R) Turnover

A type of liquidity ratio that describes the number of times a firm’s accounts receivable account is paid off

Inventory Turnover

A liquidity ratio that calculates the number of times the company sells its receivables per year

Total Asset Turnover Ratio

A type of activity ratio that evaluates how efficiently a company uses all its assets to generate revenue or sales

Fixed Asset Turnover Ratio

A type of activity ratio that evaluates how effectively fixed assets contribute to generating sales

Leverage

A company’s ability to finance debt.

Financial Solvency

A company’s tendency toward bankruptcy.

Debt-to-equity (D/E) Ratio

A type of leverage ratio that compares the company’s total debt to its equity

Debt-to-assets (D/A) Ratio

A type of leverage ratio that measures the percentage of a company’s assets that are financed by debt

Capital Structure

The mixture of debt and equity that a firm uses to finance the company.

Times Interest Earned (TIE) Ratio

A type of leverage ratio that compares company operating profit to paid interest

Return On Assets (ROA)

A type of profitability ratio that measures how efficiently a company utilizes its assets to generate net income

Return On Equity (ROE)

A type of profitability ratio that gauges the profitability generated from shareholders' equity

Profit Margin

A type of profitability ratio that provides insight into the portion of revenue that remains as net income after all expenses are deducted

Book Value

Literal value or face value.

Market Value

What others are willing to pay.

Price-Earnings Ratio (P/E)

A type of market ratio that measures the market price of a stock relative to its net income or earnings